Thursday, November 8, 2012

Is Customization The Solution?

There may or may not be a kinder, gentler future for the asset-management industry, but investors are certain to be pitched a more personalized one.

More asset managers are attempting to cast themselves as providers of "solutions," an elastic term whose meaning stretches from products such as target-date funds to services such as matching institutions' pension liabilities to assets, and from providing dependable income streams to producing inflation-targeted returns.

In some ways, it boils down to benchmark aversion and rethinking along more customized lines. That's partly a result of attrition in core areas such as equity mutual funds. The shift promises to steer the conversation away from "alpha" and trying to produce good relative performance -- by beating, say, the S&P 500 -- and toward goals that aren't defined by a stock benchmark.

Investors' unhappiness with stock funds stems from the funds' lengthy underperformance. But even people whose funds matched or beat the S&P 500 by a small margin over the past decade can't be very happy, given the weak showing of that key market gauge; investors have pulled more than $670 billion from stock funds since 2008. It makes sense for investors to think less about benchmarks if the benchmarks themselves perform poorly.

A McKinsey & Co. study underscores the industry's new enthusiasm for customization. It found that 85% of the asset managers surveyed cited solutions as a promising growth area. (The firm's two other top picks are passive index trackers and alternative investments.) Many of us know solutions as managing retirement money, college funds, or income streams. For institutions, the term might include controlling pension costs.

Chris Goolgasian, head of U.S. portfolio management at State Street Global Advisors' investment solutions group, calls the industry's fixation on benchmarks a problem. His group manages $165 billion in the solutions category, which, in its case, includes tactical asset-allocation strategies, target-date funds, and liability-driven investing. None are closely tied to stock indexes.

How much of this is simply slick marketing? The asset-growth figures suggest that something bigger is afoot. About $320 billion in net new money flowed into the solutions category, if you define it to include target-date and target-risk funds, tax-managed strategies, inflation-protected bonds, 529 college saving plans, and similar products, McKinsey found. The expectation is for the tally to pick up substantially. The average asset manager participating in the study estimated that such outcome-oriented products would account for more than one-third of flows by 2015. "The terms by which you are successful in the eyes of your clients are changing," says Kurt MacAlpine, co-author of the study.

Sure, the industry has a self-interest in making fewer comparisons to stock benchmarks when they're unflattering. And some of the "solutions" it's touting, including many target-date funds, have produced dismal results. But many investors seem to want a more customized approach, and big-picture investment thinkers have been talking about this for a while. MIT Professor Andrew W. Lo wrote about what he termed "personal indexes" more than a decade ago. Says Lo: "One size does not fit all. Buying and holding passive investment vehicles like the S&P 500 is a crude approach to what an investor really cares about for his or her own personal circumstances."

My take on the "customization solution"? To be brutally honest, it's a bunch of marketing fluff to shift investors' attention away from the abysmal performance of the money management industry.

Sure, no two pension funds are alike. They all have different liabilities and liquidity constraints and their portfolio should reflect this. But at the end of the day, it's all about alpha. Stock and bond managers have to beat the established benchmarks and hedge funds and private equity have to return absolute returns. You can "customize" your portfolio all you want, the bottom line is your internal and external managers need to deliver alpha.

And while passive investment vehicles might seem like a "crude approach" to some, the reality is that this inexpensive approach continues to outperform the majority of active managers, including smart money which is falling off a cliff.

Of the thousands of hedge funds and other vehicles registered as Securities and Exchange Commission investment advisors, more than 150 have the word "alpha" in their names. But calling yourself alpha and actually generating it are entirely different things.

Putting money into a Standard & Poor's 500-stock index fund would have gained you more than 12% so far this year, while investing in the average hedge fund would have generated just 4.8% in returns, net of fees, through September, according to hedge-fund performance tracker HFR. Even most strategies correlated with equity markets trail the S&P by a wide mark. Put simply, alpha, or the value a manager adds to returns beyond his benchmark, just isn't there. And that's what the typical hedge fund promises investors, in return for its hefty fees.

Hedge funds typically lag behind broader indexes slightly during years with double-digit S&P gains—they do have to hedge, after all—but it's rarely by this much.

Managers across all strategies are concerned about another 2008-like market crash, but in the meantime, they've been hurt by central banks' persistence at keeping interest rates low. Add in volatility and a U.S. presidential election where the top three issues are the economy, the economy, and the economy, and it's clear that hedge-fund managers are more concerned about managing risk than gambling on equities. Investors and other industry observers say that for perhaps the first time since the phrase hedge fund entered the lexicon, hot or gimmicky strategies aren't worth investing in at all. It's the manager that counts.

"It's a return to the roots of the hedge-fund industry, when it was a small group of highly talented stockpickers and fundamental investors," says John Bailey, founder and chief executive of Spruce Private Investors, which invests in 30 different hedge funds for foundations and endowments.

Sure enough, some of the stars of the industry, like Appaloosa Management founder David Tepper and Steve Mandel of Lone Pine Capital, have more than doubled the returns of the S&P this year. While others, like Third Point Capital's Daniel Loeb, haven't been able to beat the broader markets, they've at least generated the double-digit gains that hedge-fund investors expect.

Perhaps it's time, though, to re-examine those expectations. The successful managers, with years of positive track records, are more of an exception now than ever before. Bailey says he and his firm recently conducted a study of rolling hedge-fund returns since the mid 1990s, tracking alpha specifically. His findings?

"You don't want to invest in the average hedge fund," Bailey says. "Hedge-fund industry alpha has been on the decline since the mid-1990s, and is actually trending toward zero."

But Ken Heinz, president of HFR, says this year's poor performance is more a case of growing fears among hedge-fund managers that a far-reaching economic crisis is coming. More managers are emphasizing less risk, even when playing the broader stock market. Third Point's third-quarter letter to investors said the fund matched the market's gain "with significantly less exposure."

Heinz says the decline in interest rates to near zero has also hurt hedge funds' returns.

"Equities are only a portion of what hedge funds are actually investing in," Heinz states. "Right now you're sitting here with record low interest rates." Making money off debt instruments with higher interest rates is gone, he says. "The opportunities to get 15% or 20% [returns] the last few years have not been as plentiful as what they would be in an environment where governments aren't suppressing their rates."

Then there's that whole election you may have heard about. While it's unclear what type of short-term effect on hedge funds an Obama re-election or Romney win might have, the sheer uncertainty of who will be in office on Jan. 20, 2013—and what that might mean for both the Federal Reserve and central banks overseas—has kept hedge funds from stepping too hard on the gas pedal.

"Postelection, we'll have a better view," says Kenneth S. Phillips, founder and chief executive of HedgeMark, a BNY Mellon affiliate that provides risk analytics and managed-account platforms for hedge funds. "The Fed established policies in the U.S. that were not influenced by the elections, and as it got closer to the elections, they could not change those policies because it would have the appearance of playing to the other party."

Once the election is over, Phillips says, investors will be able to go back to trying to identify the managers with the most important, if unquantifiable, skill in chasing alpha: talent.

"Talent is not something that can be easily discerned during a raging bull market that's being accelerated by central-bank intervention," Phillips says.

True, talent is not something that can be easily discerned during a raging bull market but the reality is few hedge funds understood or played the macro events of the last couple of years correctly. A lot of them succumbed to the noise, reducing risk at the worst time, worrying about Grexit, a collapse of the eurozone, a hard landing in China, the US fiscal cliff and another 2008 meltdown.

More worrisome, most hedge funds still don't understand the role of quantitative easing, fearing that the Fed and other central banks are on a collision course with Armageddon. The failure to understand central bank interventions post-2008 has been the single most important factor explaining the gross underperformance of hedge funds.

Instead of worrying about customizing their portfolios, institutional investors should be asking themselves a lot of hard questions at this stage of the cycle. For example, while structured credit hedge funds are the high yield flavor of the day, are there risks in these funds? It wasn't long ago that I wrote about the death of highly leveraged illiquid strategies but it seems like in this industry, the hunt for yield makes for short memories. To be sure, some of these funds investing in CLOs are excellent but as money chases performance, a bunch of charlatans are entering the space.

I'm hardly shocked that most US hedge funds lost ground in October. There will be more pain ahead for many funds that continue to reduce risk, fearing another meltdown. Wednesday's massive selloff was yet another opportunity to buy the dip in financials, energy, technology and materials. Smart hedge funds loaded up on coal, banks, energy and tech (never mind Romney's loss!).

All this to say that investors can "customize" their portfolios all they want but at the end of the day, it's all about alpha. I've never seen so many lame excuses from money managers trying to explain or shift attention away from gross underperformance. It's truly pathetic.

Finally, read an article on how a computer-driven hedge fund Cantab Capital Partners has closed to new investors because it is not confident it can deliver the same returns with more money. CTAs have been struggling of late but investors willing to seed emerging talent in this space should contact me directly (LKolivakis@gmail.com) and I'll put you in touch with an exceptional manager who was recently let go by a Canadian bank whose managers wouldn't know alpha if it landed on their lap (however, they know all about beta, increasing allocations to credit strategies!).Below, Bloomberg’s Jon Erlichman details losses incurred by hedge funds because of the drop in Apple’s share price. He also looks at the pressure on the company to deliver during the holiday season. He speaks on Bloomberg Television’s “Money Moves.” Told you to bet on BlackBerry's revival!

Bio, contact info and your support

I am an independent senior pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest. Please remember to support my efforts by clicking on the ads on the blog but more importantly by contributing via PayPal clicking on the buttons below. Anyone can contribute any amount at any time (all tips are greatly appreciated) but institutional investors are kindly requested to support this blog via an annual subscription of $500, $1000 or $5000 CAD (third option includes specialized consulting mandates). For all inquiries and comments, email me at LKolivakis@gmail.com.

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